Tracking stock is a way to get exposure to parts of a business without having to swallow the entire company as a whole. Particularly in modern times, where companies seem to merge continuously, creating corporate behemoths with tentacles in multiple different verticals, tracking stock is a way to narrow down an investment into parts of a company that you believe in and feel comfortable with. But how exactly does tracking stock work, and how can you invest in it? Let's break it down below.
Understanding tracking stock
Tracking stocks function as shares tied to the financial performance of a particular business unit rather than the overall company. A corporation may issue these stocks to provide clarity on a division's profitability while maintaining full ownership control.
For example, a large technology firm with multiple business units, such as cloud computing, hardware sales, and various streaming platforms, might issue a tracking stock specifically for its cloud computing segment. Investors who buy the tracking stock will see their returns based on the cloud division's performance, even though the company as a whole still owns and controls the division. This approach can help a company raise capital while giving investors a way to focus on the strongest-performing areas of a business.
Are tracking stocks a good investment?
Tracking stocks lets companies highlight a division that is performing well without letting weaker parts of the company have a negative effect on investment sentiment. For example, let's say a retail company's e-commerce business is growing rapidly, but its physical stores are struggling. In this scenario, a tracking stock related to its e-commerce business allows investors to put money directly into the high-growth segment without taking on the risks of the underperforming brick-and-mortar locations. This setup can attract more investment while keeping the company's core structure intact. In many cases, companies can use tracking stocks to raise capital without selling off part of their business. If the tracked division thrives, the company may even spin it off into an independent entity in the future.
While tracking stocks offers a targeted investment opportunity, there are indeed drawbacks. Investors in tracking stocks don't actually own a piece of the company's assets; instead, they just own a share in the financial performance of one division. This means they rely on the parent company to allocate profits fairly, but if the business faces financial trouble, it could shift revenue or costs between divisions, making the tracking stock less valuable. Tracking stocks can also behave in a more volatile manner than the entire company. Just as investing in a basket of stocks is generally less volatile than investing in one single stock, investing in a whole company tends to be less volatile than only one division.
How to invest in tracking stocks
1. Find tracking stocks and verify their status
Identifying tracking stocks requires thorough research, as they are not as common as regular shares. Start by checking a company's investor relations page or recent SEC filings, such as 10-K reports, where companies disclose details about their annual financial performance. Some firms may also announce tracking stocks in press releases or shareholder meetings, so reviewing these sources can provide valuable information.
Once a potential tracking stock is identified, analyze its financials to determine if it accurately reflects the performance of the tracked division. Look at segment-specific earnings reports and compare them to the tracking stock's market performance. Be very careful; if the parent company retains excessive control over revenue allocation, it could affect the stock's profitability.
2. Compare it to regular stock options and understand voter rights
Before investing, compare the tracking stock to the company's traditional stock. Sometimes, the parent company's overall stability makes a better investment than betting on just one of its segments. Tracking stocks can experience greater volatility, especially if investors speculate on a future spinoff or major shift within the business. Pay attention to whether the tracking stock has voting rights or dividend policies, as these factors influence investor benefits and risks. Tracking stockholders usually have limited or no voting rights, meaning they cannot influence company decisions like regular shareholders. This lack of control can be a disadvantage, especially if the parent company decides to restructure or sell the tracked division.
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Example: Disney and its tracking stock strategy
In the late 1990s, during the height of the dot-com bubble, Disney (DIS +1.50%) decided to create a separate stock for its internet division called Go.com. The move allowed investors to gain exposure to Disney's growing online business without affecting the valuation of its core media and theme park operations. When the dot-com bubble burst, Go.com struggled, leading Disney to shut down the unit and retire the tracking stock. Since most of Disney's assets were unrelated to the internet at the time, investors that held regular Disney stock as opposed to the Go.com tracking stock would have fared much better after the bubble burst.
For investors considering tracking stocks, they must make sure to weigh their benefits against the potential risks. While they provide a way to invest in a high-performing part of the business, the lack of direct ownership and limited voting rights can make them a riskier bet than traditional stocks.
